What to Consider Before Taking a Hardship Withdrawal
Abrupt bad news can be stressful. So are the financial hazards tied to an unexpected change in fortune. Whether it’s a medical emergency, home repair, or tuition payments, it can be tough to know how to pay for expenses when personal budgets turn tight. A hardship withdrawal from a 401(k) retirement account might be one way to access cash—but it can come with its own headaches.
Even before the coronavirus pandemic, the US Federal Reserve found that a significant percentage of Americans do not have enough cash or savings on hand to fully cover an unexpected expense of $400 , such as a car repair after an accident or a pricy medical bill—much less enough funds to pay for even more costly mishaps.
When faced with a sudden expense, individuals who’ve been saving for retirement in a 401(k) might wonder: Is it wise to take an early withdrawal?
After all, a hardship withdrawal from a retirement account could free up some emergency cash. But, what even qualifies as a hardship withdrawal with a 401(k)?
Defining a 401(k)
A 401(k) is an employer-sponsored retirement savings plan. Typically, employee contributions are automatically deducted from their paychecks (pre-tax) and deposited directly into a dedicated account. In addition to financial incentives such as contribution matching, in which some companies match employee payments into their 401(k), such accounts provide specific tax benefits.
When an individual contributes to a 401(k), they do not pay income tax on that money, or on any increases to the value of 401(k) investments, until the money is disbursed come retirement.
(Note: traditional 401(k)s are funded with pre-tax dollars, while Roth 401(k)s are funded after tax, so withdrawals from a Roth 401(k) are tax-free. There is also another type of retirement fund, called an Independent Retirement Account or IRA, which is self-funded and not employer sponsored. This blog refers to traditional 401(k)s.)
What Is a Hardship Withdrawal from a 401(k)?
While the money in a 401(k) account remains the investor’s, it’s not as simple as withdrawing funds from a savings or investment account. But, in some specific cases (and if the employer permits it), it is possible for individuals to borrow funds from your 401(k) as a “hardship withdrawal.”
A hardship withdrawal is permitted by the IRS to cover “immediate and heavy financial needs ” that may arise due to recognized economic hardships. Federal rules require that 20% of the withdrawal be withheld for taxes, and there is also an additional 10% penalty on early 401(k) withdrawals (though there are some scenarios that are exempt from this additional tax ).
What Qualifies as a Recognized Hardship?
What qualifies as a hardship withdrawal? The IRS is quite specific in defining what counts. For starters, the money must be absolutely necessary to satisfy a qualifying, urgent need. If other finances are available—for example, owning a vacation home or assets belonging to a spouse—the funds in the 401(k) are no longer considered “necessary.” What’s more, the funds withdrawn cannot be more, after tax, than the amount of money needed to address the hardship.
The types of expenses that qualify for a hardship withdrawal are also very specific. According to the IRS, these include:
• Some medical expenses
• Buying a home as your main residence
• Tuition and school-related expenses
• Payments necessary to avoid being evicted from a home (or foreclosure on a primary residence)
• Qualifying costs for repairing home damage
• Burial or funeral expenses
Understanding Hardships Caused by COVID-19
The recent CARES Act also allows for hardship withdrawals for needs tied to the coronavirus pandemic. It’s worth noting that the 10% penalty mentioned earlier does not apply to hardship withdrawals of up to $100,000 for expenses incurred due to the COVID-19 pandemic. Additionally, taxes are not withheld at the time of the withdrawal (but individuals will have to pay them at income tax time).
Taking a Hardship Withdrawal: What’s the Process?
Not all companies allow employees to withdraw money from their 401(k), even on a hardship basis. If an individual is in need of a hardship withdrawal for reasons that fit the IRS criteria, they could speak with their 401(k) plan administrator. When hardship withdrawals are permitted, an individual may still need to provide proof of their economic circumstances. The documentation requirements can vary here, depending on the hardship.
Under IRS rules, the amount of an early withdrawal must be the same as the actual need to pay for that recognized hardship. Again, it may be required to provide documentation for these expenses. When calculating one’s financial needs, it can be helpful to account for any income taxes that will be withheld or owed on the withdrawn amount.
While it is ultimately up to the employer whether a hardship withdrawal is permitted, recent rule changes make it easier for employees to access the funds they need. For example, the Bipartisan Budget Act, passed in 2018, did away with the requirement that individuals first seek a loan before taking a hardship withdrawal. The law also removed restrictions on withdrawing employer-contributed funds as well as on making new 401(k) contributions, or receiving employer-matched contributions, for six months following the withdrawal.
Costs of Taking a Hardship Withdrawal
Just because a person can take a hardship withdrawal doesn’t mean they necessarily might want to. In addition to taxes and penalties that could amount to nearly a third of the value of the withdrawal, there can be other drawbacks.
When funds are withdrawn from a 401(k), it’s money that the individual will, likely, need later (when they retire). Withdrawing funds also means no compounding interest—one of the key benefits of saving for retirement. Unless an individual can later replace the funds in a 401(k) through catch-up contributions, permitted for workers aged 50 and older, borrowing from a retirement account now could actually create future financial difficulties.
The money in a 401(k) is also protected from creditors and cannot be seized in the event of bankruptcy, unlike other assets. While rules for hardship withdrawals require a person to draw on other assets first (if they exist), it can make good sense to keep protected funds untapped (if possible). Even if an employer permits hardship withdrawals and the individual qualifies, they might want to consider other sources of funds to cover their emergency needs.
Emergency Funds: Alternative Sources to Hardship Withdrawals
Considering the costs and potential losses that can come with a hardship withdrawal, some investors choose to investigate other sources of emergency funds when unexpected expenses pop up. Each will have its own pros and cons, so the solution will depend on an individual’s unique financial situation and options. Here are some possible sources to tap:
Selling Off Physical Assets
Whether it’s a classic vinyl collection, closet full of vintage clothes, or even a car (hello, public transit and ride sharing), people looking for more liquid cash might want to take stock of what they own and don’t regularly use. Selling one or two big-ticket items may be enough to meet the financial needs of the moment. Alternately, some people prefer to liquidate more belongings or assets, if needed.
Freelancing or Gig Work
While a side hustle may not be practical or possible in all hardship situations—for example, if someone experiences a health emergency that impairs their ability to work or is in need of fast money—taking on more work can help individuals to grow savings (without adding to their debt load). Temp agencies and gig work platforms can reduce bottlenecks associated with finding, applying for, and accepting a second job, allowing some individuals to earn much-needed dollars faster.
Borrowing Funds
For others, borrowing from a family member is one potential way to access cash (without depleting retirement savings).Generally speaking, family members who are willing and able to assist will not charge interest and might understand the seriousness of a sudden hardship
Taking Out a Personal Loan
If an individual has already exhausted existing assets, family network and additional work options, getting approved for a personal loan may be one additional option to pursue. In this case, a private lender provides the funds as a lump sum and the money borrowed then gets paid back, with interest, over time.
Interest rates on a personal loan depend on a number of factors, such as whether the loan is secured by an asset (secured loans are less risky to the lender, and thus cost less, because if the loan is not repaid on schedule, that asset may be seized). If an interested borrower doesn’t meet all the requirements for a personal loan (or qualifies only for a high-interest rate loan), getting someone to co-borrow a loan may help to make this option more manageable.
Few things are more stressful than needing money to handle an unexpected hardship. But numerous options, from tapping into existing assets to applying for a private loan, exist to help cover unanticipated costs.
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